Natasha de Terán explores the market for structured property products and finds real estate investment trusts becoming popular and the derivatives market gathering steam.

Property investing used to require getting your hands dirty with good old bricks and mortar; dealing with the vagaries of low occupancy rates and/or recalcitrant tenants, as well as diluted returns thanks to fiscal impositions. If bankers are to be believed, those days are now as good as over, thanks to the simultaneous arrival in the property sector of real estate indices, real estate investment trusts (Reits), derivatives tools and structuring techniques.

Investment trusts

The concept of Reits was pioneered in the US in the 1960s. Australia followed in the 1970s, since when Japan, Hong Kong, Singapore, France, Belgium, Greece, Turkey, the Netherlands and Bulgaria have jumped on the bandwagon. The UK is the latest market entrant, having allowed Reits since January this year.

Reits are publicly traded vehicles that invest solely in income-producing real estate assets. In each regime, companies that wish to convert to Reit status are subject to slightly different regulations, but for investors the advantages are pretty much the same the world over. The benefits over bricks and mortar funds include greater tax efficiency, better liquidity and less ‘cash drag’ – less cash sitting around waiting to be invested.

Since the introduction of Reits, just over a dozen UK property companies have converted. European Reit regimes would gain a further boost if Germany and Italy follow suit, as expected, with similar structures this year.

Property derivatives

If 2007 is set to be the year of the Reit in Europe, property derivatives will not be far behind. The derivatives market has fast been gathering steam in the past few years, particularly in the UK, where more than 300 deals worth about £5bn have been struck in two years. More recently, deals have been struck in Hong Kong, Germany and France.

The earliest property derivatives contracts were typically basic swaps, with one party betting that property returns would outperform a set benchmark (say, the IPD All Properties index) within a given time and the other party taking the reverse bet. More recently, investors and property companies have used the derivatives to take bets on individual market sectors, such as offices or retail property, and to split out capital growth from rental growth.

The reason why the UK’s property derivatives market is the most developed is due to the quality of data behind the indices to which the derivatives contracts are linked. The underlying data – that is gathered by the Investment Property Databank, the leading data firm for the industry – is widely believed to be far superior than that amassed in any other country.

The indices have not only spawned a burgeoning trade in over-the-counter derivatives, they have also facilitated listed structured products. In July last year, for instance, Goldman Sachs launched a listed structured property product on the London Stock Exchange. The UK IPD Tracker gives 100% exposure to UK commercial property. At maturity, the investor receives a one-for-one exposure to the performance of the index return, subject to a 2.8% annual cut (this, the bank says, is comparable with the total annualised cost of buying a UK commercial property unit trust and selling it after five years).

Structured products

Thanks to the relative youth of the markets (at least in Europe), few property investors are yet familiar with the indices, Reits or property derivatives. Retail investors – who some believe will eventually propel these markets – are a case in point. But in many cases, specialist property investors do not have the risk management systems or investment mandates that would allow them to trade in the products either, which is where the structured product specialists come in.

Kara Lemont, European head of interest rates and foreign exchange structuring at BNP Paribas, says that her bank sees a “huge amount” of potential for structured products based on property derivatives. “There is tremendous demand from those that are long property assets, those that have no exposure, as well as from those that want to refinance existing exposures – say from investors who want to diversify into property abroad but don’t want to spend the time required or don’t have the experience investing in the physical markets in those regions. They are turning to property derivatives and structured products, as they find these can save lots of time and money.”

New interest

David Slater, head of property derivatives trading, Europe, at BNP Paribas, says that a good portion of the interest in property derivatives is coming from fixed income investors who would normally only go for capital protected or capital guaranteed products. “They thus use structured products to gain exposure to baskets of European property assets or to individual country property markets together with some form of capital guarantee,” he says.

A lot of the other investors involved in the market come from property backgrounds, are typically not as familiar with derivatives, and so often feel more comfortable buying a structured note rather than doing a total return swap, he adds.

Barclays Capital is another leading player in the nascent property derivatives business, but the bank is equally active in Reits, having recently launched a successful £35m Reit-based structured product in Asia. Alex Robinson, a director in the investor solutions group at Barclays Capital in London, says that his group tends to prefer to do structured products based on Reits over and above products linked to conventional property shares. “This is because they offer a purer form of exposure to property assets than shares do and tend to be less volatile. However, as there are no liquid futures on Reit indices, they can be quite expensive to hedge, and that does put some limits on what you can do.”

Advocates of both property derivatives and Reits-backed products are keen to stress how structuring techniques can provide tailored trading and hedging opportunities that were previously unheard of in the property market. They say that investors looking to sell their overall exposure to the market, in exchange for picking up exposures to particular pockets of the market, or investors interested in trading the spreads between markets, will all find that property derivatives and structured Reits products offer an efficient and economic way of doing so.

Change of profile

Mr Robinson says that his group has already quite widely deployed structuring techniques to change the investment profile of the property sector. “Over the past three or four years, as more and more pension funds have increased their property weightings, so there has been stellar growth in asset prices and a simultaneous reduction in yield,” he explains. “We have used structuring techniques to put the property asset class back into the traditional low-risk, high-income bucket – investors in the products sell away some of the upside and get it back in the form of income. We can also use structuring techniques to convert income to capital or to change returns according to the desired tax profile of an investor.”

Most of the products have so far been sold to private clients and fund managers but those selling the products are pinning their hopes on the investor universe opening up, most particularly to hedge funds and retail investors. Mr Slater admits that the markets are not yet liquid enough for the hedge funds to get involved on a regular basis, but he nonetheless believes it will be so before long. “This market could eventually be much bigger than the inflation market, not least because most retail investors feel more comfortable with property than they do with inflation,” he says.

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